So what's going on with oil prices? I think it is important to keep in mind that prices are driven by the balance between supply and demand. Therefore, to understand changes in prices, one needs to consider both supply side and demand side influences.
Demand Side: I am putting this first because this is the side that most people overlook and which has been increasingly important over the past decades or so. In general, higher oil prices have been driven by increased demand for oil (and energy in general) in the developing world. The overarching story is that demand for oil has grown faster than the supply of it and that factors influencing global demand have become more important in driving prices than they were in, say, the 1990s.
At the risk of oversimplifying, for the last decade, oil producers have basically produced as much as they can (making the supply of oil somewhat fixed) and more fluid factors influencing demand (such as the economic strength of oil consuming markets) have driven price changes. Of course, with supply so tight, any shock to supply, like the Libyan uprising, resulted in a spike in prices. However, in general, good economic forecasts and strong growth in US, Europe, Japan, and China have tended to raise the price of oil while bad economic forecasts and recessions in any of those market have tended to lower prices.
For instance, oil prices dropped precipitously in the end of 2008 as the US entered the Great Recession. Oil had been selling a over $130/barrel in June and was below $40 by January 2009 all do to the economic misfortune of the largest consumer of oil in the world.
Today, the US economy is doing well but Germany is going into a recession (which will have ripple effects in Europe) and China (the second largest consumer of oil) just had the slowest economic growth in years. Meanwhile, India (never forget India) is having lackluster growth. So, at a global level, forecasts for demand are somewhat uncertain and bleak. A side effect of this is that the dollar has gained in value against currencies like the Euro, which has driven down the dollar dominated price of oil even further (though we are talking about a 10%-ish change here).
Supply Side: Meanwhile, back at the ranch (as in in North Dakota and Texas) hydraulic fracking has allowed the US to dramatically increase domestic production of crude oil. This chart from Mark Perry shows the impact of shale oil on US production:
As a result of this increased domestic production, US imports of crude have dropped to their lowest levels (as a % of total US consumption) since the 1970s. This has left China in the position of being the largest global importer of liquid fuels and put the US (or rather US oil producers) in the position of rivals to Saudi Arabia (and other oil producers) for the US oil market.
This is significant because it means that the Saudis are competing for market share and, if they cut production to raise the price of oil (or at least put a floor under the price), they will also be keeping US shale oil producers in business. This is probably the reason they are blocking moves by OPEC to reduce production quotas. Of course there are conspiracy theories out there suggesting that the US and Saudi Arabia are colluding to drive oil prices down to weaken oil producers like Russia, Venezuela, ISIS, and Syria. While these theories are sexier than talk of market positions, they seem to elevate secondary considerations to a level of primacy.
Furthermore, theories of collusion between the US and Saudi Arabia posit a commonality of interest between the nations that ignores the fundamental change in both the US-Saudi economic relationship. Until recently, the US and Saudi Arabia had a basic consumer-producer relationship. While issues affecting the price of oil were inherently zero-sum in nature (and increase in price was good for the Saudis and bad for the US), the overall relationship was one of mutual benefit. That is, both sides gained from having a stable pattern of exchange and the Saudis (US) had a vested interest in maintaining the economic health of the largest consumer (producer) of oil in the world.
The rise of US shale oil producers as rivals to Saudi production complicates the relationship. In general, the competition for market share between producers is entirely zero sum and, potentially, a fight for survival. Therefore, the US is now less of a monolithic entity to the Saudis as it encompasses both a large set of consumers and a growing set of rival producers. However, in the current situation, the Saudis have the option to do something that simultaneously benefits US consumers and hurts rival producers, i.e., keep pumping oil despite the drop in prices. If you add to that the fact that, at any given price, curtailing production cuts Saudi income, then one hardly needs to suppose political collusion with the US to explain their decision to keep producing.
If you want a sexy narrative, though it maybe a bit fantastical, one might try thinking of the current situation as being in part a contest between the Saudis and US shale oil producers. Hydraulic fracking was initially a high cost way of extracting oil that depended on prices above $50 or $60 per barrel. The question is whether US shale producers can cut costs to stay in business at lower prices.
While having the price of your product drop is never good for an industry, it is often an impetus for productivity increasing innovation. So far, US oil producers have been protected by financial hedges they purchased to insure themselves against a drop in prices. It will be interesting to see if they can use that financial cushion to fund innovations that allow them to survive lower oil prices. However, there is almost certainly no way that they can achieve the low costs of Middle East oil, so something will have to give somewhere else.
Back to Demand: As Nick Cunningham comments in his article on the top five factors affecting oil prices, the cure for low prices is low prices. Lower prices spur greater consumption, which then raises prices. So a direct effect of lower prices may be an increase in global oil consumption that puts a floor on prices. Cunningham notes that US gasoline consumption has risen, when you look at the data to which he refers, it is hard to see a big change, especially in terms of global usage.
Of course low oil may have a secondary effect by spurring faster economic growth. While lower oil prices are a somewhat mixed blessing for the US economy, they should be a more unmitigated boon for China which doesn't produce much oil of its own. Also, lower oil prices might help India beat its projected growth rates in 2015. However, one of the reason we have lower prices is that the forecasts for these countries economies are generally poor. While those forecasts probably didn't include $50/barrel oil, the information available to investors suggested weak demand in the immediate future and so we are left to hope for (or against) something surprising.
Effect on US: All this begs the question of whether low oil prices are good for the US economy. At first blush, it seems obvious that low prices are good for the US consumers (and I am certainly one to argue that the interests of consumers are the primary interests of the society). However, the fly in the ointment is that growth of the US oil industry has been a big part of the economic recovery, as Mark Perry illustrates in the following graph:
The graph above shows that grow in employment in Texas (largely driven by the growth in shale oil production) has been a significant part of employment growth in the US. Add that to the more obvious hit to the bottom line of oil giants like Exxon and BP and we can't easily dismiss the impact of a hit to that industry. Indeed, this is why Wall Street has jitters.
Even so, at a secondary effect level, the US economy (especially the so-called Main Street, as opposed to Wall Street) might gain more from a boost in consumer spending and confidence driven by lower gas prices than it loses in the oil producing industry. Indeed, if Congress takes advantage of low gas prices to raise the gas tax and fund more highway construction, that alone would have a positive impact on the economy. It is important to keep in mind that US government expenditures have been flat for the past 4 years (see FRED graph below) and so some additional spending that doesn't add to debt may be called for.
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